International Monetary System

Organization of Lecture ALTERNATIVE EXCHANGE RATE SYSTEMS A BRIEF HISTORY OF THE INTERNATIONAL MONETARY SYSTEM THE EUROPEAN MONETARY SYSTEM Costs and benefits of a single currency

Alternative Exchange Rate Systems Overview : If people who don’t ordinarily use the same currency are going to trade, there must be some way of exchanging currency. (If you want a Porsche, you’ve got to get German marks, or now the euro). There are an enormous number of exchange rate systems, but generally they can be sorted into one of these categories Freely Floating Managed Float Target Zone Fixed Rate Hybrid

Under a floating rate system, exchange rates are set by demand and supply. The model of demand and supply is extremely useful in explaining exchange rates under a floating system (just make sure you keep track of what currency is purchased and what is sold). Any number of factors might influence exchange rates, including price levels interest rates economic growth

Important Note: Even though we may call it “free float” in fact the government can still control the exchange rate by manipulating the factors that affect the exchange rate (i.e., monetary policy)

Alternate exchange rate systems: Managed Float (“Dirty Float”) Market forces set rates unless excess volatility occurs, then, central bank determines rate by buying or selling currency. Managed float isn’t really a single system, but describes a continuum of systems Smoothing daily fluctuations “Leaning against the wind” slowing the change to a different rate Unofficial pegging: actually fixing the rate without saying so. Target-Zone Arrangement: countries agree to maintain exchange rates within a certain bound What makes target zone arrangements special is the understanding that countries will adjust real economic policies to maintain the zone.

Alternate exchange rate systems: Fixed Rate System One way to do this is to dictate an exchange rate and shoot people who try to trade currency at anything other than the official exchange rate. Price controls are hard to enforce (and even if they could be enforced lead to a misallocation of resources).

An alternative is to simply instruct the monetary authority to buy stand willing to buy or sell currency at the desired rate. A fixed rate system is the ultimate good news bad news joke. The good is very good and the bad is very bad. Advantage: stability and predictability Disadvantage: the country loses control of monetary policy (note that monetary policy can always be used to control an exchange rate). At some point a fixed rate may become unsupportable and one country may devalue. (Argentina is the most dramatic recent example.) As an alternative to devaluation, the country may impose currency controls.

Final note Not every exchange relationship has to be the same

A Brief History of the International Monetary System Overview Pre 1875 Bimetalism 1875-1914: Classical Gold Standard 1915-1944: Interwar Period 1945-1972: Bretton Woods System 1973-Present: Flexible (Hybrid) System

The Intrinsic Value of Money At present the money of most countries has no intrinsic value (if you melt a quarter, you don’t get $.25 worth of metal). But historically many countries have backed their currency with valuable commodities (usually gold or silver)—if the U.S. treasury were to mint gold coins that had 1/35th ounces of gold and sold these for $1.00, then a dollar bill would have an intrinsic value. When a country’s currency has some intrinsic value, then the exchange rate between the two countries is fixed. For example, if the U.S. mints $1.00 coins that contain 1/35th ounces of gold and Great Britain mints £1.00 coins that contain 4/35th ounces of gold, then it must be the case that £1 = $4 (if not, people could make an unlimited profit buying gold in one country and selling it in another)

At various times some countries have minted coins in both gold and silver (referred to as bimetallism) The U.S., for example, has circulated gold and silver coins at the same time. In principle such a system can function effectively in an environment where different countries back their currency with different metal. For example, during part of the 19th Century, Great Britain was on a gold standard, Germany was on a silver standard, and France minted both gold and silver coins. The franc/pound exchange rate was set by the relative gold values of the currencies while the franc/mark rate was set by the relative silver values of the currency. (Think about how such a system implicitly sets the pound/mark rate.) Gresham’s Law, however, creates a potential problem. People will tend to horde the currency that is relatively valuable and spend the currency that has less value. Following discoveries of gold in the U.S and Australia in the mid 19th Century, the intrinsic value of gold fell relative to the value of silver. The French people, quite sensibly, held on to their silver coins (or melted them down) and spent their gold.

The Classical Gold Standard (1875-1914) The Classical Gold Standard had two essential features Nations fixed the value of the currency in terms of Gold is freely transferable between countries Essentially a fixed rate system (Suppose the US announces a willingness to buy gold for $200/oz and Great Britain announces a willingness to buy gold for £100. Then £1=$2)

Advantage of Gold System Disturbances in Price Levels Would be offset by the price-specie-flow mechanism. When a balance of payments surplus led to a gold inflow Gold inflow (country with surplus) led to higher prices which reduced surplus Gold outflow led to lower prices and increased surplus

Interwar Period Periods of serious chaos such as German hyperinflation and the use of exchange rates as a way to gain trade advantage. Britain and US adopt a kind of gold standard (but tried to prevent the species adjustment mechanism from working).

Bretton Woods System: 1945-1972 German mark British pound French franc Par Value Par Value Par Value U.S. dollar Pegged at $35/oz. Gold

The Bretton Woods System (1946-1971) U.S.$ was key currency valued at $1 = 1/35 oz. of gold All currencies linked to that price in a fixed rate system. In effect, rather than hold gold as a reserve asset, other countries hold US dollars (which are backed by gold)

Real GDP in German During B-W Period

Collapse of Bretton Woods (1971) U.S. high inflation rate U.S.$ depreciated sharply. Smithsonian Agreement (1971) US$ devalued to 1/38 oz. of gold. 1973 The US dollar is under heavy pressure, European and Japanese currencies are allowed to float 1976 Jamaica Agreement Flexible exchange rates declared acceptable Gold abandoned as an international reserve

Current Exchange Rate Arrangements (IMF Classification No national currency (e.g., dollars in Panama and Euros in Italy) Currency Board: Explicit commitment to fix exchange rates to some foreign currency (Hong Kong fixed to dollar) Other fixed rate systems fixing the countries currency to a single currency or some basket of currencies (allowing some narrow fluctuations of less than 1%)

Current Exchange Rate Arrangements (IMF Classification Crawling pegs: exchange rate adjusted at a preannounced rate, usually in response to some objective qualitative indicator (e.g., Costa Rica). Floating within crawling bands Managed float: authorities manipulate the exchange rate but do not announce their intentions Independent float.

The Mexican Peso Crisis On 20 December, 1994, the Mexican government announced a plan to devalue the peso against the dollar by 14 percent. This decision changed currency trader’s expectations about the future value of the peso. They stampeded for the exits. In their rush to get out the peso fell by as much as 40 percent.

The Mexican Peso Crisis The Mexican Peso crisis is unique in that it represents the first serious international financial crisis touched off by cross-border flight of portfolio capital. Two lessons emerge: It is essential to have a multinational safety net in place to safeguard the world financial system from such crises. An influx of foreign capital can lead to an overvaluation in the first place.

The Asian Currency Crisis (1997) In 1996 several Asian countries experienced an inflow of nearly $100 billion in foreign capital. This explosion of credit led to a kind of speculative bubble in some sectors (e.g., real estate). In mid-1997 the Thai bhat came under much pressure. The Thai Central Bank tried to defend the bhat by drawing down foreign exchange reserves. In the end, however, they had to devalue and the bhat lost about 40% of its

The Asian Currency Crisis The Asian currency crisis turned out to be far more serious than the Mexican peso crisis in terms of the extent of the contagion and the severity of the resultant economic and social costs. Many firms with foreign currency bonds were forced into bankruptcy. The region experienced a deep, widespread recession.

The Argentinean Peso Crisis In 1991 the Argentine government passed a convertibility law that linked the peso to the U.S. dollar at parity. The initial economic effects were positive: Argentina’s chronic inflation was curtailed Foreign investment poured in As the U.S. dollar appreciated on the world market the Argentine peso became stronger as well.

The Argentinean Peso Crisis The strong peso hurt exports from Argentina and caused a protracted economic downturn that led to the abandonment of peso–dollar parity in January 2002. The unemployment rate rose above 20 percent The inflation rate reached a monthly rate of 20 percent

The Argentinean Peso Crisis There are at least three factors that are related to the collapse of the currency board arrangement and the ensuing economic crisis: Lack of fiscal discipline Labor market inflexibility Contagion from the financial crises in Brazil and Russia

Currency Crisis Explanations In theory, a currency’s value mirrors the fundamental strength of its underlying economy, relative to other economies. In the long run. In the short run, currency trader’s expectations play a much more important role. In today’s environment, traders and lenders, using the most modern communications, act by fight-or-flight instincts. For example, if they expect others are about to sell Brazilian reals for U.S. dollars, they want to “get to the exits first”. Thus, fears of depreciation become self-fulfilling prophecies.

The European Experience THE EUROPEAN MONETARY SYSTEM (1979) established to provide exchange rate stability to all members by holding exchange rates within specified limits by establishing a kind of target-zone method Close macroeconomic policy coordination required. Currency Crisis of Sept. 1992: System brakes down. Britain and Italy forced to withdraw from EMS and finally collapses in 1993. Maastricht Treaty Called for Monetary Union by 1999 (moved to 2002) Established a single currency (the euro) Called for creation of a single central EU bank (ECB) Adopts tough fiscal standards for entering countries For example, countries could not carry a total debt of more than 60% of GDP, and inflation rates had to be no more than 1.5% than the average inflation of the three lowest inflation nations.

Benefits of a single currency Reduces exchange rate risk Allows for larger capital markets which may provide greater liquidity May promote a sense of political unity among nations sharing the currency.

Costs of a Single Currency Lack of national monetary flexibility. Leaving countries vulnerable to “asymmetric shocks” (problems in one country not common to all)